Job Changes and Pension Rollover Options

At the time of a job change, thinking about your pension options may not be your highest priority, but the decisions you make (or do not make) can have repercussions throughout your working career and into your retirement.

A common way people handle pension assets in a 401(k) during a job transition is to leave the money in their old employers plan.  Typically an ex-employer will allow this if the amount in the plan is more than $5,000.00.  If the amount is $5,000.00 or less, normally an employer will distribute the money in the form of a check to the ex-employee that will become a taxable distribution to the recipient if it is not placed (as an indirect rollover) with another retirement plan custodian in 60 days or less.

There may be advantages to leaving funds in your old plan if that plan has multiple high performing investment options and the assets will continue to grow tax deferred by leaving it there.  About 5% of 401(k)plans have a loan provision which you may be able to use if your plan includes it. You will not be able to make new contributions to your old plan, but you can always move your balance at a later date.

A  direct custodian to custodian transfer will have no tax implications and maintain the tax deferred status of your accounts. (Note: Plans can have different types of administrators which can be Custodians, Trustees or Third Party Administrators (TPA's) or a combination.  It pays to know the differences between each for the new plan you select. To keep things simple, I will generically describe them all as custodians for this entry.)

If the amount is over $5,000.00 your employer will ask you to complete a form that identifies your choice to make a rollover or transfer to a new custodian or to take a taxable distribution.  If you elect a distribution there will be withholding from your distribution check for taxes and penalties if they apply.

If you are over 59 ½ years of age, and you cash the check rather than roll it over into a new plan, you will be liable for income taxes on the entire amount in the current tax year at a rate based on your current tax bracket, which may be higher than the amount withheld by the custodian.  If you are under 59 ½ and cash the distribution check, you will pay a 10% penalty imposed by the IRS in addition to the current taxes due.

Some people elect to take a lump-sum distribution and pay taxes and penalties in order to have immediate and unrestricted access to their funds, but depending on your age, this could cost you up to 1/3 of your current assets and much, much more in the long run. Consider this alternative very carefully and avoid it if you can. Remember you are giving up tax deferral on these assets forever on what could be significant earnings and if you liquidate at the wrong time, you may realize current losses in your portfolio.

The worst effect of this option is that you may drastically reduce your income at retirement.  For example, If you were able to earn 12% compounded on your assets, the “Rule of 72” says that your assets would double every 6 years. If you have $50,000 and are 18 years from retirement at 65, this would mean trading about $35,000 today (after taxes and penalties) for what could have become $400,000.00 through tax deferred growth by age 65. In effect you would be paying $365,000 dollars of retirement funds to spend $35,000 today.

If your old plan had limited investment options, or was not performing well, you may want to consider moving the assets in that plan into a plan with more options, but there are several things to think about. If you leave or are severed from an employer with a 401(k) plan and do not get a new job with a traditional employer you have options:

1. A Rollover into a Individual Retirement Plan (which can be self directed, with nearly unlimited investment options) and low contribution limits or:

2. If you are self employed and generating income from your business, consider starting a 401(k) sponsored by your business (which can also be self directed). A properly drafted 401(k) plan can include legal distributions at age 55 and a loan provision in addition to much higher contribution limits than an IRA. (See the entry on Solo K Plans for more information on these features)

3. If you are Self Employed you can also consider a Simplified Employee Pension Plan (SEP) which has benefits in certain situations but does not offer the flexibility of a Solo K.

If your income is high enough, you can make tax deductible and/or after tax contributions to a Qualified plan and make non-deductible contributions to an IRA as well to get tax deferred growth from the IRA.

Rollover to an IRA

By rolling over 401(k) assets into an IRA you keep the tax deferred status of your funds, but you will be moving from a “Qualified Plan” in to an IRA, which is a “Non-Qualified Plan”.  There are limitations imposed on any IRA because of the distribution rules that apply to “prohibited transactions” in all IRA’s, which are applied differently to a Qualified Plan (401(k), 403(b), 457).  IRA’s do not have a loan provision.  You cannot take a personal loan from your IRA, period. You can take a personal loan from a properly drafted 401(k).  You could split your rollover into several IRA’s for asset protection or to test your ability to self direct by rolling over a portion of your assets into a self directed plan.

If you do not start your own business after a job loss/job change and are not happy with the 401(k) plan at your old employer, a rollover into an IRA can at least offer control of your investments through self direction.  Once you start your own business, you can always sponsor a 401(k) and rollover all or part of the assets in any existing IRA you may have into your personal 401(k).

If you find a new job right away, you can elect to rollover the money from your old employers 401(k) into your new employers 401(k) or you still have the option of rolling over the assets in your old plan into an IRA and start a fresh 401(k) or other Qualified Plan (403(b) or 457) with your new employer.

Other Options

One of the options offered to employees at the time of severance is to rollover 401(k) assets into a “Qualified Annuity”.  Annuities can provide a fixed income at retirement with capital preservation and “Equity Indexed Annuities” can offer upside potential in addition to capital preservation.  The assets are transferred and maintain tax deferred status until distributions are taken.

This is a tempting option for many, since an annuity offers fixed payments that you cannot outlive. If you consider this option, do some serious due-diligence and comparison shopping.  These types of products can have higher costs with heavy back end commissions paid for through “surrender charges” and may have state taxes on the premiums. A transfer into a Qualified Annuity is an irrevocable decision.

Note: For the purposes of this entry I have used the term “Rollover” for the movement of assets from one pension plan to another through a check to the plan holder.  In some scenarios, a direct transfer of funds occurs from custodian to custodian and is called a transfer rather than a rollover.  A rollover occurs when there is a distribution direct to a plan holder, who then may place the funds with a new Trustee/Custodian/TPA or takes the current tax hit if the rollover does not occur within 60 days of the distribution.

All distributions are reported to the IRS for tax purposes.  Direct transfers (existing Trustee/Custodian/TPA to new Trustee/Custodian/TPA) are not reported to the IRS.  Depending on your situation, there are times when a distribution by check to a plan holder is faster than a custodian to custodian transfer.  If you are planning to rollover your proceeds and have identified your new Trustee/Custodian/TPA, you can request a check to the new custodian "FBO" for the benefit of (YOU).  You have 60 days to get the check to the new custodian without tax consequences.

There are many nuances to Pension Rollovers and this entry is not intended to be either tax, legal or investment advice, but rather as information to help you avoid the most common problems associated with pensions and job changes. It is not an all inclusive summary of your options. Before you do anything with pension funds between jobs, do your own due diligence and homework and ask lots of questions of anyone you are considering transferring your hard earned assets to.